Psych 101: Don't Go Mental Over High P-E Ratios

If your daughter got an A in math, you probably wouldn't say: "Your skills are clearly overvalued. You have nowhere to go but down."

If she received an F, you wouldn't say: "Great job; you've set yourself up for a big improvement."

No one would react that way. Yet for some bizarre reason, that's how some people react to a stock that's near a new high. And these same investors will seek stocks with low price-earnings ratios.

The P-E ratio is essentially a grade from the market. Yet many people gravitate to low P-E stocks. A new high is also a grade from the market. But many investors regard stocks at new highs as scary and dangerous. Well, all stocks are scary and dangerous. You can lose money playing a "safe" stock and you can lose in a "dangerous" stock. That's the reason for the rule to sell any stock that falls 7% or 8% below your buy point.

Research shows that you are most likely to make money in a stock making new highs. Such stocks often carry high P-E ratios.

Grocery stocks illustrate this. Many carry low P-E ratios. Just a few carry high P-E ratios.

For instance, Kroger (NYSE:KR) and Supervalu (NYSE:SVU) currently carry P-E ratios of 13 and 5, respectively. As the accompanying chart shows, the five-year P-E average is also low. The Relative Price Strength Ratings are abysmal.

Meanwhile, Whole Foods Market () and Fresh Market (NASDAQ:TFM) feature P-E ratios of 37 and 49, respectively. Whole Foods also has a high five-year P-E. Fresh Market is an initial public offering.

Whole Foods has provided growth investors more opportunities for sharp gains than Kroger has in recent years. Whole Foods also corrected more than Kroger during the recent bear market. But that's no surprise to growth investors. The idea is to time your exit appropriately, not buy and hold.

Last July 16, one pundit declared Whole Foods the "stupid investment of the week." A research firm put it on a list of the "most dangerous stocks for July." A second firm noted in July that Whole Foods carried a P-E of 32 and suggested that Intel (NASDAQ:INTC) and Microsoft (NASDAQ:MSFT) were better values.

Whole Foods is up 42% since July 16, while the Nasdaq advanced 28%. (Whole Foods cleared an early buy point as it gapped up Oct. 15. It then cleared a 40.43 buy point in a handle Nov. 3. It will report Q4 results after Wednesday's close.)

If your daughter got an A in math, you probably wouldn't say: "Your skills are clearly overvalued. You have nowhere to go but down."

If she received an F, you wouldn't say: "Great job; you've set yourself up for a big improvement."

No one would react that way. Yet for some bizarre reason, that's how some people react to a stock that's near a new high. And these same investors will seek stocks with low price-earnings ratios.

The P-E ratio is essentially a grade from the market. Yet many people gravitate to low P-E stocks. A new high is also a grade from the market. But many investors regard stocks at new highs as scary and dangerous. Well, all stocks are scary and dangerous. You can lose money playing a "safe" stock and you can lose in a "dangerous" stock. That's the reason for the rule to sell any stock that falls 7% or 8% below your buy point.

Research shows that you are most likely to make money in a stock making new highs. Such stocks often carry high P-E ratios.

Grocery stocks illustrate this. Many carry low P-E ratios. Just a few carry high P-E ratios.

For instance, Kroger (NYSE:KR) and Supervalu (NYSE:SVU) currently carry P-E ratios of 13 and 5, respectively. As the accompanying chart shows, the five-year P-E average is also low. The Relative Price Strength Ratings are abysmal.

Meanwhile, Whole Foods Market () and Fresh Market (NASDAQ:TFM) feature P-E ratios of 37 and 49, respectively. Whole Foods also has a high five-year P-E. Fresh Market is an initial public offering.

Whole Foods has provided growth investors more opportunities for sharp gains than Kroger has in recent years. Whole Foods also corrected more than Kroger during the recent bear market. But that's no surprise to growth investors. The idea is to time your exit appropriately, not buy and hold.

Last July 16, one pundit declared Whole Foods the "stupid investment of the week." A research firm put it on a list of the "most dangerous stocks for July." A second firm noted in July that Whole Foods carried a P-E of 32 and suggested that Intel (NASDAQ:INTC) and Microsoft (NASDAQ:MSFT) were better values.

Whole Foods is up 42% since July 16, while the Nasdaq advanced 28%. (Whole Foods cleared an early buy point as it gapped up Oct. 15. It then cleared a 40.43 buy point in a handle Nov. 3. It will report Q4 results after Wednesday's close.)

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